Reforming the with-profits rules

The FSA's rule changes for the operation of with-profits funds, which come into force on 1st April 2012, focus on the fair treatment of policyholders and effective, independent challenge to governing bodies.

But the regulator has modified some of its original proposals in light of feedback received from the industry and plans to carry out further work on issues affecting the mutual with-profits sector.

Poor management of with-profits funds has been a concern for the FSA since the near-collapse of Equitable Life in 2000. In 2005, following a major review, it introduced specific rules and guidance in chapter 20 of the Conduct of Business Sourcebook (COBS 20).

But in 2008 theTreasury Select Committee criticised the FSA for failing to provide a robust framework for managing conflicts of interest. In response, the FSA carried out a further with-profits review to see how firms have been putting the COBS 20 rules into practice.

As a result of the with-profits review,many mutuals raised a number of concerns with the FSA about how the COBS rules were impacting them which led to the regulator engaging with mutuals over the next few years in a process called "Project Chrysalis".

One outcome of the with-profits review was the March 2011 consultation paper (CP11/5) "Protecting with-profits policyholders", which proposed changes to the rules on how with-profits funds are managed. A year later, on 7th March 2012, the FSA published a policy statement (PS12/4) on how it intends to proceed, together with a summary of responses received and the final text of the amended rules in COBS 20.

Planned work on customer communications has, however, been put on the back burner while the regulator prioritises its further investigation into mutuals and on preparing for Solvency II.

Policyholders' interest

Many of the proposals in the earlier 2011 consultation paper (CP11/5) were based on the premise that with-profits policyholders have an interest in all parts of the with-profits fund and a contingent interest in any surplus which may exist before a distribution.

Industry respondents, however, particularly those in the mutual sector, maintained this approach was "incorrect and misleading". They argued that legal and beneficial ownership of a with-profits fund lies with the insurer and that the interest of with-profits policyholders was limited to those parts of the fund that will meet expected payouts under their contracts.

The FSA, however, has not changed its mind: "Our approach in this [policy statement] is based on our considered view that the interests of with-profits policyholders are more extensive than the narrow interpretation put forward by some regulated firms," it concludes.

"Indeed we believe that fair treatment of with-profits policyholders requires us to take a much broader view of the relationship between those policyholders and firms than can be encapsulated by a legal analysis of the ownership of the firm’s assets."

But the regulator acknowledges that a proper balance needs to be struck between the different interests in a with-profits fund:

"We believe that much can be achieved by more effective governance arrangements, although this is not sufficient in itself. In several places we have modified our proposals in response to consultation in order to assist firms to implement changes in practice, or we have decided not to proceed for now with new rules where we believe that further consultation may be necessary.

"In particular we intend to conduct further work on the mutual with-profits sector. We will re-examine the arguments that have been put to us both before and during the course of this consultation process and we will review our proposals on possible ways forward."

Fair treatment

The FSA has retained proposed guidance to introduce its high-level view of policyholders' interests in a with-profits fund at the start of COBS 20.

This sets out the numerous potential conflicts of interest that might give rise to unfair treatment of policyholders: between shareholders and with-profits policyholders, with-profits and non-profits policyholders in the same fund, with-profits policyholders and the members of a mutual or the management of a company, or between different classes of with-profits policyholders, such as those with and without guarantees.

The guidance also states explicitly that with-profits policyholders have an interest in the whole and in every part of the with-profits fund into which their policies are written.

"We consider the guidance on the interests of with-profits policyholders in a with-profits fund to be an important statement of the FSA’s approach to the scope and application of COBS 20 rules and to how it expects firms to behave towards with-profits policyholders," it says in the policy statement.

But the regulator acknowledges concerns raised by mutuals on the practical difficulties of balancing directors’ duties to their members and the rules on with-profits policyholders. It does not, however, accept that its rules could bring directors into conflict with their duty to promote the success of the company for the benefit of all its members under the Companies Act 2006.

The FSA has also decided to proceed with converting its current guidance into a rule requiring firms to take reasonable care to ensure that all aspects of its operating practice are fair to the interests of its with-profits policyholders and do not lead to an undisclosed or unfair benefit to shareholders or other persons with an interest in the fund.

"In any event a firm will need to ensure that any decisions it takes comply with Principle 6 which requires firms to treat their policyholders fairly, so this [new] rule simply makes sure that a firm ensures that its operating practices incorporate these principles of fairness," the policy paper states.

Distributions

Under existing rules, a firm must determine on an annual basis whether it has an excess surplus in the fund. If so, and if the firm cannot justify retaining it, the excess should be distributed to policyholders and (if it is a shareholder-owned firm) shareholders.

The distribution to with-profits policyholders must not be any less than the "required percentage", which may be specified in the firm's articles or reflected as established practice in its Principles and Practices of Financial Management document (the PPFM). If neither of these applies, it must not be less than 90%.

The definition of required percentage will now be amended to clarify that, unless the contrary is contained in the firm's rules or a court order, any distribution must be allocated in accordance with any established practice, regardless whether this is specified in the PPFM. Established practice would have to be adequately demonstrated by the firm's policyholder communications

The FSA comments: "This is particularly applicable to with-profits funds in shareholder-owned firms, although it is also capable of being applied to a mutual with-profits fund."

The regulator will not, however, be proceeding with a proposed rule and guidance that was intended to clarify how the 90:10 distribution ratio rule applies to mutuals unable to demonstrate that their distribution practice has been clearly and unambiguously communicated to their with-profits policyholders.

Mutuals were concerned that the proposal sought to apply current standards of disclosure to policies that were sold many years ago. Some said the question of what constitutes a distribution would also need to be addressed since non-profit policyholders may also be members of a mutual's common fund and benefit from different applications of surplus, such as lower premiums or alternative benefits of membership.

Taking this feedback into account, the FSA has decided "it would not be appropriate for us to seek to make Handbook provisions on these issues at this time".

"This is an area of considerable complexity and many firms consider it to be at the heart of the debate about the future of the mutual life sector in a financial environment in which a declining volume of with-profits business is being written," the policy paper states.

"We need to look again at these issues which, as set out in our ‘Dear CEO’ letters, are not limited to the interests of with-profits policyholders, but also involve members of mutuals who hold non-profit policies.

"We are also minded to consider further the broader consumer interest in having a diverse market in financial services providers in which mutuality has a future alongside proprietary companies. We will aim to broaden the debate and return to this, potentially in a Discussion Paper in 2012/13."

New business

COBS 20 requires a firm to write new business only on terms that, in the reasonable opinion of its governing body, are unlikely to have a "material adverse effect" on the interests of existing with-profits policyholders.

This is now amended to remove "material" from the test as the FSA believes that, over time, minor or immaterial detriment may erode the value of a fund in a material way and reduce the money available for distribution.

Under the new rule, new business can only be written if the governing body is satisfied, so far as it reasonably can be, and can demonstrate, that there is likely to be no adverse effect on with-profits policyholders' interests. This includes future as well as existing policyholders.

Firms will be required to carry out or obtain "appropriate analysis" to back up this conclusion, which must be made available to the with-profits committee.

The change is described as a "modest tightening of an existing rule," intended to prevent inappropriate depletion of the estate, for instance by new business being deliberately priced on loss-making terms or failing to generate enough volume to cover all the associated costs.

The proposal met with some opposition during the consultation process, particularly over the scope of analysis that would be required to be able to show that the new business is not likely to cause detriment to policyholders' interests. But the FSA has decided to go ahead:

"We recognise that there are two views of the appropriateness of regulation in this area, affecting as it does not only the outcomes for policyholders but also the uses of the estate, which is particularly sensitive territory for some proprietary firms," the policy paper states.

"Nevertheless, in order further to secure the protection of consumers, we will proceed with this change to our rules and guidance, but we have also taken into account some of the detailed comments from providers."

As a result, firms will need to carry out or obtain only appropriate advice (rather than all appropriate advice) and will be able to take a proportionate approach in determining what is appropriate.

Consideration of the impact of new business should take into account the terms, likely volume and duration of each new product line when viewed as a whole and with reference to the with-profits policyholders in the relevant fund viewed together, rather than to each individual policy.

Short-term deferrals of the emergence or distribution of surplus or a marginal reduction in the Equity Backing Ratio will not necessarily amount to adverse impact "so long as the new business is financially self-supporting and adds sufficient value so that policyholders continue to be treated fairly", the policy paper states.

"We have taken what we believe to be a pragmatic approach to incorporating these points of detail into the Handbook text. We believe that this will provide a sound basis on which new business can continue to be written, bringing new policyholders into a fund, subject to adequate safeguards being in place to ensure appropriate protection of existing and future policyholders."

A new transitional rule has also been added - that new business based on compliant decisions taken by a firm’s governing body before 1st April 2012 will be deemed to be compliant with the new rule until 1st July 2012.

Closed funds

Under existing rules, firms closing funds to new business have to provide the FSA with a run-off plan within three months showing how they would ensure a fair distribution of the fund and any surplus. This, however, only applied to funds that have closed to new business since 2005.

Under the new rules, this requirement extends to all closed funds. It was originally proposed that funds that closed before 2005 would have to submit their plans within three months of the proposed rules coming into force. The FSA now acknowledges this was rather a challenging timescale and has amended the deadline to 31st December 2012.

The policy paper comments that firms should already have the information necessary to produce a run-off plan proportionate to the issues faced by the fund. The FSA will, however, require firms to produce only information that is relevant to the efficient and effective run-off of the fund while delivering fairness to policyholders.

Reductions in business

A with-profits fund writing very little new business may not be in a very different financial position to a closed fund, but it may resist formal closure, possibly because of the potential damage to its reputation.

The FSA wants to encourage firms experiencing a significant drop in new business to consider the option of closing their with-profits funds at an earlier stage. Under the new rules, firms will be required to discuss their position with the regulator for treating their various stakeholders fairly whenever they experience substantial and sustained falls in either the volume of new non-profit insurance contracts or the volume of new with-profits policies written into the with-profits fund.

The FSA does not propose to define "substantial" and "sustained" as firms should already have regard to the existing Principle 11 disclosure requirements.

The accompanying guidance suggests the discussion should include whether the firm needs to take any action with regard to policyholder interests – including whether to stop taking on new business altogether.

It was originally proposed that firms in this position would need to come up with and maintain fair distribution plans based on current and future business prospects and a management plan that included contingency arrangements if their projections were not met.

However, the FSA has taken on board comments about the costs implications for smaller funds, and the duplication of effort with what is already required by the Individual Capital Assessment process for larger firms and the Own Risk and Solvency Assessment (ORSA) soon to be required under Solvency II.

As a result, the regulator has dropped plans for separate fair distribution and management plans: "We will consider whether to revisit these proposals in due course, once we have greater clarity on the contents and level of detail available from the ORSA and other Solvency II reporting", the policy paper states.

MVRs and strategic investments

Other provisions in the new rules aim to ensure firms exercise their discretionary powers in a way that is fair to with-profits policyholders.

For instance, under existing rules, firms have been allowed to apply "market value reductions" (MVRs) on the grounds of surrender volumes alone.

Under the new rules, however, a firm must not "in so far as is reasonably practicable" make an MVR to the face value of with-profits policies unless the value of underlying assets is, or is expected to be, less than the assumed face value of the policy and the MVR is not greater than is necessary to reflect the impact of the difference in value on the relevant surrender payment. If so, then the volume of surrenders, transfers, or other exits from the fund that there has been, or is expected to be, is a factor that a firm may take into account when considering whether to make a MVR and if so, its amount.

Conflicts may also arise if the firm makes or retains any "strategic investments" (such as head office buildings or major stakes in businesses related to the firm) from the fund.

Under the new rules, a firm's governing body must satisfy itself so far as it reasonably can be (and be able to demonstrate) that the purchase or retention of the investment is likely to have no adverse effect on the interests of with-profits policyholders. Guidance sets out the sort of issues the governing body should take into account and a new rule requires the firm to keep adequate records of the strategic purpose for which the investment was purchased or retained.

The FSA has also made a transitional rule with the effect that retaining a strategic investment based on compliant decisions taken by a firm’s governing body prior to 1st April 2012 will be deemed to be compliant with the new rule until 1st October 2012.

Charges

Under existing rules, firms are prohibited from charging with-profit funds for costs that are more than the costs incurred in operating that fund. This is designed to prevent any profit element being deducted.

The FSA proposed to amend the rule to prevent other group companies, such as service companies, making charges in excess of their costs. In other words, charges from in-house service providers would not be able to include any profit element.

In relation to fees charged by intra-group asset managers, respondents to the consultation pointed out that these were commonly lower than fees charged to external clients and were usually determined on an arm's length basis and on commercial terms.

Other points made by respondents were, firstly, that the proposal to prevent a profit element should not seek to overturn any existing expense charging bases set out in court-approved schemes of transfer which established separate ring-fenced funds. Secondly, that the proposal would deter "white knight" bids for mutuals in difficulty because the acquirer would find it more difficult to make an adequate return on capital from a take-over or rescue to treat its own with-profits policyholders fairly.

In light of these comments, it has been decided not to proceed with the change as proposed "in the immediate future".

"In recognition of consumer concerns," the policy statement continues, "we will consider alternative approaches, perhaps allowing for charges to include an element to represent the realistic impact of risk transfers from the fund to the service provider and allowing firms to compare costs with charges over an extended period of say five years. There could also be better disclosure of costs. This would be sufficiently different from the proposal on which we consulted to require fresh consultation."

The paper also points out that the FSA's existing proposals on governance focus on the fairness of charges to with-profits policyholders, "so this is an area that will continue to receive scrutiny both within a firm’s internal governance and by the regulator."

In addition, both the Financial Services Consumer Panel and Which? have asked the FSA to look again at the extent to which pension scheme deficits are charged to with-profits funds in proprietary firms to ensure that there is no disproportionate levy on the fund.

Reattributions

Firms with an excess surplus in their with-profits funds have until now been able to choose to make a reattribution (where policyholders agree to give up their rights in the inherited estate in return for payment) rather than a distribution.

In the recent Aviva reattribution, however, Mr Justice Norris pointed out that the two processes are fundamentally different. Under the new rules, the FSA has removed the reattribution option, so that firms with an excess surplus will only be able to make a distribution.

When a reattribution is being proposed, the firm will have to discuss - and justify - its plans with the regulator in advance. In particular, it must be able to set out a solid basis for its view that there is excess surplus and its proposals for distributing the excess before any proposed reattribution of the remaining fund.

A proposed rule that would have enabled policyholder advocates to communicate directly with policyholders without the firm approving the content has been revised in light of industry concerns about reputational damage and inappropriate disclosure. The amended rule requires the policyholder advocate to consult the firm about policyholder communications and agree messages where possible, but with the residual right to communicate independently if agreement is not reached in a reasonable time.

The FSA has also decided not to proceed with a proposal that would have removed a firm's ability to use solvent schemes of arrangement to enable the majority of policyholders to bind the minority in a reattribution.

"We recognise that preventing all reattributions that seek to bind the minority can be seen as inflexible and that the regulator will have the opportunity to object in court if appropriate," the policy paper concludes. "The courts can take their own view of the fairness of any scheme."

Governance

Governance rules in COBS 20 require "some" independent judgment to be exercised in assessing the firm's compliance with its PPFM and addressing conflicts of interest. Under current rules, this requirement can be met by appointing an individual, a non-executive director or a with-profits committee to protect policyholders' interests.

The FSA's review, however, found that, although most firms had set up committees (or made equivalent arrangements), some were unable to show that their boards took sufficient notice of the committee's views or that policyholders' interests were being adequately taken into account.

In its March 2011 consultation paper, the FSA proposed to make it compulsory for firms with large funds (i.e. with assets of over £500m) to set up with-profits committees under terms of reference that would have to be discussed with the FSA and made publicly available on the firm's website.

Responses to the consultation showed a lack of consensus in governance issues, with the result that the FSA is "not sufficiently persuaded to go ahead with our proposal in the form in which we put it forward."

It has also decided not to proceed with a provision that firms with more than one with-profits fund should appoint the same with-profits committee for all of them. It will, however, be giving further thought to the various options.

"Firms should note that, in our view, having seen all the various arrangements in action, we continue to believe that it is best practice to have a with-profits committee, at least for complex funds," the policy statement concludes.

"We think that there is considerable merit in the suggestion that we make a with-profits committee the general rule except for those firms whose low level of complexity makes one unnecessary and which would retain the existing ability to use an independent person in those circumstances to fulfil the role. We recognise that firms may need further pointers as to what factors may be regarded as relevant to deciding that a fund is non-complex. In our view such a change would be sufficiently different from our proposal to require re-consultation."

The regulator has, however, also decided not to require that all members of the with-profits committee must be independent of the firm.

"We believe that if committees have an independent majority, possibly with a senior independent non-executive or external person chairing the committee, then they can reasonably include internal appointments to link them more effectively to the business."

"In defining independence, firms should have regard to the guidance we have issued which is in line with the [Financial Reporting Council's] guidelines, including the annotated version used by mutual insurers. This is in line with the FRC's "comply or explain" rubric". In effect, the regulator will leave it to boards to assess the independence or otherwise of their appointments.

Again, the FSA has also made a transitional rule that firms' existing governance arrangements are deemed to comply with the governance provisions until 1st July 2012.

The new rules will help strengthen the with-profits committee's influence within the firm. The same rules will apply to the alternative arrangements set up by smaller firms.

For instance, the with-profits committee must satisfy itself that the PPFM properly reflects how the fund is actually run. The governing body will be required to consult the committee in a timely manner on all matters the committee could reasonably expect to be consulted on, and provide it with enough information to be able to discharge its functions.

The regulator's vision for the with-profits committee is that it should be providing advice and challenge to the board and, where appropriate, recommendations. New guidance encourages a clearer separation between the committee's recommendations and the governing body's decisions, requiring both to be clearly documented – and the committee can require the FSA to be notified if the firm departs in a material way from its recommendations.

The FSA is also to go ahead with its proposal to require firms with a website to publish terms of reference for with-profits committees on their websites and, for firms without websites, to make them available on request.

In addition, the with-profits committee can obtain external advice if it considers the advice to be necessary to perform its role effectively. The costs of such advice may be met by the fund or the firm or may be shared according to whether the issue is wholly or partly to the benefit of the firm rather than policyholders.

The policy paper confirms that the list of issues for a with-profits committee in the original consultation paper would not be expanded but also should not be treated as exhaustive.

Finally, the FSA has agreed to add guidance to the rules that it expects the notification mechanism for the with-profits committee to alert the FSA to significant disagreements between the board and the committee to be used only in exceptional circumstances.

Next steps

The FSA has promised to look again at the issues facing with-profits mutuals "as soon as possible", given the EU imperatives and domestic regulatory changes.

"We do not share the gloomiest predictions from some firms within the mutual with-profits sector about the impact of protecting policyholders’ interests on the future of the sector," the policy statement concludes.

"Having said that, we note the trend of demutualisation and of consolidation within the mutual sector that has taken place over the past decade and we see little sign that this is set to change in the near future. Those trends are unlikely to be seriously affected by the changes we have proposed, which are in any event incremental."

The regulator expects there to be continuing demand for the sort of long-term savings products which the life industry has traditionally provided. "The underlying issue is more one of confidence and here it is for firms to communicate the benefits of long-term life assurance saving to consumers, rather than to focus on the impact of domestic with-profits regulation."